(Pexels – Hoover Dam, Built to relieve Great Depression joblessness)
As you have likely heard, the state of America’s infrastructure is generally poor. Dams and bridges are reaching the end of their safe life with many becoming structurally deficient. Significant renovations are also needed on roads, the electrical grid, and airports. This is partially due to the fact that infrastructure has made up a declining share of U.S federal spending for decades, currently making up only 2.5%.
Potential infrastructure overhaul bills have been floated for years. However, with the economy remaining in a generally poor situation, the time is right to pursue economic stimulus. The new administration and Congress are already preparing multi-trillion-dollar public infrastructure stimulus bills for the coming year. With bipartisan support generally strong and the jobs market needing a boost, I suspect a successful bill will be seen early next year. This spending splurge may be a great alpha opportunity for investors.
As recently detailed in “XME: Mining Sector Gaining On Inflation Expectations, But China Risk Has Grown“, the base metal mining and steel production industries are likely to see significant gains from a renewed emphasis on infrastructure. However, ETFs such as the SPDR S&P Metals and Mining ETF (XME) are highly sensitive to China’s construction sector which will likely continue to slow over the coming years due to overdevelopment.
A potentially safer best on U.S. infrastructure can be found in the Global X U.S Infrastructure Development ETF which trades under the ticker PAVE. PAVE seeks to invest explicitly in companies that stand to benefit from a potential increase in U.S. infrastructure activity. This includes raw materials companies like those in XME but also heavy equipment, engineering, and construction companies. Overall, PAVE is much more diversified than XME and potentially has more to gain from a sweeping infrastructure overhaul spending bill.
As you can see below, PAVE has seen decent performance since the November election, outperforming the S&P 500 ETF (SPY) by a few points:
Considering the need for secular growth in the infrastructure industry and the growing likelihood of a spending bill, I believe this outperformance trend is likely to continue over the coming year. To make matters better, lackluster performance in the infrastructure industry over the past decade has led to generally low valuations in many of these firms. There has been a decline in earnings due to COVID, so TTM valuations are higher than normal, but valuations that use long-term earnings forecasts are generally low.
A Look at PAVE’s Holdings
Most of the companies in PAVE are in the industrials sector with the secondary sector being materials. To a large extent, PAVE allows investors exposure to the entire supply chain of the infrastructure process. This includes mining companies, steel producers, railroads, distributors, and construction companies. The breakdown of its subindustries is shown below:
As you can see, the ETF is largely equal-weighted between its major subindustries with none holding a concentrated portion. This is beneficial because it limits PAVE’s exposure to risks in any one subindustry. In general, companies within the infrastructure supply chain operate at very low-profit margins, thus creating significant earnings volatility. This is a major reason why companies like U.S. Steel (X), Cleveland-Cliffs (CLF), and United Rentals (URI) are prone to 50%+ annual price moves. Fortunately, much of that volatility is mitigated by diversifying between these subindustries.
Of course, 2020 has also led to a general reduction in earnings for most of these companies as capital expenditure levels have plummeted and the pace of construction has slowed. Firms in PAVE are generally cheaper than those in the S&P 500 with the ETF having a weighted-average P/E ratio ranging from 22-26X this year (the S&P 500’s is 28X). As you can see below, valuations are generally highest for the top-ten companies within PAVE, most of which have forward P/E valuations around 27X:
Unfortunately, the reduction in earnings this year has not led to a reduction in share prices. Since I firmly believe the long-term earnings growth of the companies in PAVE is likely to be well above average, I would not say the stocks are overvalued given long-term earnings forecasts. However, they could easily become much cheaper if the broader equity market sees another sell-off. Certain companies such as United Rentals, which I have been bullish on since before COVID, still appear undervalued. However, for investors who care about shorter-term performance, it may be best to wait for a correction before placing a large bet on PAVE.
The Congressional Catalyst
Of course, a decline in the general stock market would only further encourage Congress to pass a sweeping infrastructure bill. This may already be the case considering the past series of jobs reports have almost all been worse than expected. Leading civil engineers believe that fixing U.S. infrastructure would require an estimated $4.6 trillion. Funny enough, this is nearly equal to the size of the entire public U.S. industrials sector which has a combined market capitalization of $4.8 trillion which happens to be the same size as the total federal budget for FY 2021.
Any infrastructure spending bill would likely last over a multi-year period and most likely include joint state and private financing. That said, this goes to show that the U.S. government has the capacity to spend on such a bill and, more importantly, that it will likely significantly boost the value of many associated industrial companies.
A large infrastructure bill has been floated many times over the past few years, often leading to a temporary spike in investor interest in many of the companies within PAVE. However, no large bill has ever been passed and many of these companies have continued to generally underperform the broader equity market. Certain companies with thin margins like the construction industry such as Fluor Corp. (FLR) have even flirted with bankruptcy in recent years.
While Congress has not yet passed a spending bill, the time to bet on one is perhaps better than ever. U.S. infrastructure still desperately needs improvement, but now the jobs market does as well. As we go into 2021, the coming COVID vaccine makes it likely that restrictions will finally fade; however, looking at skyrocketing permanent unemployment, the economy will still need stimulus. A multi-trillion dollar infrastructure bill will be one of the few ways to hit two birds with one stone. It is still possible that the Senate will again block such a bill; however, bipartisan support has grown since the election.
Such a spending increase does yet not seem to be priced into PAVE and its constituents. The earnings forecasts for most of PAVE’s holdings only predict a recovery, but not significant growth thereafter. If this is one of the first major acts of the new administration and Congress, it could encourage a large breakout in PAVE as investors discount the value of secular growth in the infrastructural development sector.
The Bottom Line
While the bullish setup is strong, PAVE is not without risks. It is a bit more volatile than the S&P 500 with an annual performance standard deviation of 26% and a beta of 1.3X. This means the fund often gains or loses around a quarter of its value each year and usually rises or declines 1.3% for every 1% change in the S&P 500. Importantly, the equity market as a whole remains in a precarious and expensive position.
Furthermore, while I believe PAVE is likely to garner outperformance, its holdings are cyclical and therefore could see considerable valuation declines if the S&P 500 sells off again. Investors who would rather avoid a potential 15-30% decline (as witnessed in March 2020) may want to hold off on betting on PAVE. That said, if your investing time horizon is more than two years, the ETF appears to be a strong allocation candidate.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.